'Cash Accounting' is a very simple method of accounting where sales or payment receipts are recorded in the period the money is received, and expenses are recorded in the period they are paid. If you report sales and expenses when the money changes hand you are using Cash Accounting methodology.
This method is sometimes favored by small businesses, because it is simple and very straightforward to follow. It indicates how much cash the business has on hand and makes calculating tax easier.
Most countries will have a threshold of when a company is no longer able to report using Cash Accounting methodology. For example, the threshold in the UK is £150,000 and Limited companies and Limited Liability Partnerships can’t use cash basis.
'Accrual Accounting' is a method where revenues and expenses are recorded within the actual period the sales invoice is raised or the purchase is made, regardless if payment is made in that same period.
Corporations are required to use accrual accounting under the GAAP (Generally Accepted Accounting Principles). Accrual Accounting leads to a much more accurate picture of the business performance and thus leads to better decision making.
The difference between the two basically comes down to timing.
Example: Profit & Loss Report prepared under both methodologies
Sally is a sole trader who sells and buys on credit. She has negotiated favorable terms from suppliers which gives her 90 days credit whereas she sells on 15 days credit.
Sally purchases 60 units from her supplier on June 1st at a cost of £120. With the credit terms, payment will be due in August.
On June 2nd she sells 15 units for £60
On June 20th she sells 25 units for £100
Cash Accounting methodology
In our example, the cash for the first set of sales is received in June (provided the customer pays within the credit terms) and the cash for the second lot of sales would not be received until July (15 days after purchase).
The money for the stock was due after 90 days therefore was paid in August.
As this example illustrates, Cash Accounting methodology can lead to a very skewed view of the financials of the company and does not lend itself very well for long term decision making.
The example highlights the main drawback of cash accounting.
The company shows a profit during June and July, however August shows a hefty loss. Decisions made when the company appears profitable (only because bills have not been settled) may be very different from decisions based on an ‘August’ month.
When applying for loans to facilitate future growth, many financial institutions will require that the accounts be prepared under GAAP, meaning they are prepared under the Accrual Accounting methodology.
Accrual Accounting methodology
This example of Accrual accounting clearly shows the sales that were made in June and the expenses that are directly related to these sales. This is an illustration of the matching principle. Accrual accounting results in more accurate Financial Statements, which consequently helps improve the financial decision making for the company.
Tax consequences of Cash Accounting
A business can only claim expenses that occur within the accounting year.
Example of a tax year is January – December.
For instance, if a company using Cash Accounting methodology, has expenses at the end of Dec 2018 that will be paid in 2019, they will only be able to claim these expenses in 2019.
Similarly, if a company provides a service in 2018, but is paid in 2019 – the revenue is included in 2019 return, and not in 2018 return. Some see this as a benefit of Cash Accounting, as it can delay the payment of VAT on these sales, given that it would not make economic sense to pay VAT on income that has not yet been received.
The deferral in tax is only temporary as payments smooth out over the years. You can switch between Cash and Accrual Accounting each year, but it can create an additional administration burden. There are also very strict rules in place to ensure that income and expenses can be included in the return only once.
The third methodology is known as 'Hybrid Accounting', and some businesses may decide it is the best one for their business. It is a blend of Cash Accounting and Accrual Accounting, however, there are some special rules that IRS have produced and that must be followed, if the hybrid model is chosen.
This methodology can also be tricky for people that do not have a great deal of accounting knowledge, so we advise you to consult with your accountant regarding the suitability and TAX implications.
Special Rules that must be followed, if the hybrid model is used:
- If you report income using the cash method, you must also report expenses using the cash method;
- If you report income using the accrual method, you must also report expenses using the accrual method;
- If you have inventory, you must use accrual accounting to record sales and purchases.